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Customers of the Pandora music-streaming service love it. They get access to a vast library of songs, with personalized recommendations delivered to their desktops or mobile devices, all at little to no cost.

For investors, however, the last part of that formula poses a bit of a problem. Pandora Media Inc.'s shares have lost nearly half their peak value as profits continue to elude the company. A number of recent commentaries have called Pandora "a great business, but a lousy stock."

Unfortunately, it's not such a great business, either – and that likely means more woes for its investors.

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Let's start with what there is to like about the company. It is the pioneer and largest player in Internet-based radio, and is believed to have at least two-thirds of the market. Its system for selecting new music for users based on their likes – the Music Genome Project – is regarded as industry-leading technology.

It had more than 62 million active listeners at the end of November; they spent 1.27 billion hours on the service that month, a figure up 58 per cent from November, 2011. Revenue in the 12 months ended Oct. 31 was $383-million (U.S.), up nearly 60 per cent over the prior year.

But profits? Um, not so much. The company had a net loss of $31.8-million during that period. Its EBITDA, or earnings before interest, taxes, depreciation and amortization, was negative $24.7-million.

The problem is royalties – the payments Pandora makes to the artists for the privilege of playing their songs.

In the company's most recent quarter, it spent $65.7-million for the rights to play the music that brought the company $120-million in revenue, nearly 90 per cent of which was from advertising on its free service (versus subscription fees for its $36 per year ad-free offering). The royalty rates are set to increase each year through 2015.

What can Pandora do about this? As it happens, the company is lobbying for U.S. legislation – the Internet Radio Fairness Act – that will cut its royalty rate.

Analyst James Marsh of Piper Jaffray Cos. Inc. listened to a Congressional hearing held in late November and came away with the impression Pandora was less likely than before to prevail. "The fact that Pandora was asking again for legislative relief after already receiving previous settlements sat poorly with some legislators. … We thought Pandora's status as a larger publicly traded company seemed to make it less sympathetic than the 'startup' it was during its last trip to D.C."

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Also unhelpful: The 100-plus artists, from Billy Joel to Rihanna, who signed a mid-November statement criticizing Pandora for not paying artists enough for their music.

Mr. Marsh has a "neutral" rating and $11 price target, nearly 30 per cent higher than the share's recent price in the mid $8 range. Yet he helpfully lays out the bear case on the stock.

"While many investors seem fixated on listener hour growth, content costs [royalties], are also denominated in hours, so operating leverage is lacking here unless ad rates can be pushed higher," he says.

It's rates that have to budge, because Pandora can't run more ads per hour on its free service without losing listeners, he argues. But, unfortunately for Pandora, its users are shifting to mobile, where ad revenue per hour is actually lower.

All of this would appear to be a recipe for a financial flop – a highly popular one, but a flop nonetheless. While Pandora is an industry leader, it's losing money even with tens of millions of listeners. "In most industries, market leaders must deal with competitors trying to dislodge them on a daily basis, but at least they have benefits of generating market leadership profits," Mr. Marsh notes.

To be sure, Pandora's shares aren't necessarily locked into an irrevocable downward spiral. The stock is one of the most heavily shorted on the New York Stock Exchange, meaning there are plenty of people betting on its decline. A positive earnings report or two in 2013 may send these shorts scurrying to cover their positions, pushing Pandora shares up through their buying.

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That, however, seems to be the best bull argument for the shares. In the long run, Pandora seems likely to become a great example of a company with happy customers and unhappy shareholders.

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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More


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